Thursday, March 3, 2011

China’s Highly Unequal Economy

During a round table with business leaders during Chinese President Hu Jintao’s visit to the United States in January, US President Barack Obama stated optimistically that ‘With China’s growing middle class, I believe that over the coming years, we can more than double our exports to China and create more jobs here in the United States.’ To be sure, that is a reasonable expectation. When other Asian economies like Japan and Korea grew toward the GDP per capita level of $10,000, sizable middle class populations did indeed emerge.

However, when looking under the bonnet at China’s economic engine, it’s clear that a growing middle class with rising disposable income and consumption is missing. Instead, there’s an economy that is still dominated by state owned firms and state-led investment, as well as by rapidly rising inequality. Instead of an enlarging urban middle class, China is increasingly splitting into a small upper class that spends freely on luxury goods, and a remaining population whose earnings and savings are eroded by inflation and state confiscation.

The underlying dynamics are clear in a recent statistical release by the government. First, real urban disposable income rose a comparatively tepid 7.8 percent in 2010, despite economic growth of nearly 10 percent. However, urban retail sales of consumer goods grew 14.5 percent. While the growth of consumption is good for China's economy, the pattern of this growth suggests rising inequality.

The biggest growth in consumption included jewellery (46 percent), furniture (37 percent), cars (34 percent) and construction material (34 percent). Essentially, these are items related to the spending of the upper class. These ‘consumer’ goods also made up 33 percent of all retail consumption in China. The large size and strong growth in luxury items implies that grey income was substantial in 2010, as suggested by a Credit Swiss report authored by Prof. Wang Xiaolu.

In this report, released last year and based on a survey of urban households in 2009, Wang found nearly 1.5 trillion dollars in grey income unreported in the official household income numbers. He further found that over 60 percent of this grey income accrued to the top 10 percent of households. The latest numbers also suggest that while income of normal households likely grew at around 8 percent, the top 10 percent of households may have seen income growth above 25 percent.

A growing middle class is also absent among recent college graduates. According to the Ministry of Education, only 68 percent of college graduates in 2010 were able to find permanent employment. Even among those who found employment, wages were often no better or sometimes even worse than those for migrant workers in factories. Unlike the rest of the world, however, China enjoyed a spectacular 10 percent growth rate. This impressive growth, however, didn’t translate to high paying jobs for college graduates. In major cities, many college graduates live as an ‘ant tribe,’ packed tightly in small dormitory rooms with four or more roommates.

And, lest we begin to think of China as a dynamic market economy, the latest data showed that of the 27.8 trillion yuan in fixed asset investment, 15 trillion was accounted for by investment undertaken by state-owned enterprises or investment in real estate. Even among the ‘joint stock’ firms, many are actually state-controlled. Thus, at least in terms of investment, the state still controls the lion's share. Meanwhile, well-financed state owned enterprises have nationalized firms in the coal, automobile, and steel industries in recent months, meaning competition and efficiency in these sectors might actually have suffered from large-scale, state-led investment.

Why does China have an economy that is highly unequal and dominated by the state? The answer is quite simple when considering China’s political system and contemporary history. Despite economic reforms that liberalized goods markets and the labour market, the state continues to hold a tight grip over most of the financial institutions. The financial sector in essence takes money from foreign exchange earnings and from household savings and channels it to state-owned firms controlled by the central or local government. Having little choice, households in China must deposit money in the state banks, and when there’s inflation as there is today, they earn a negative real interest rate from the banks because the government fixes deposit rates at a level that is below inflation. Meanwhile, real estate developers with political connections and large state-owned enterprises can borrow money at interest rates that are near zero in real terms. In effect, the Chinese financial system channels wealth from ordinary households to a small handful of connected insiders and state-owned firms. To be sure, other Asian countries have also pursued this state-led financing model. But China has pursued it for the longest period of time. Meanwhile, there’s still no liberalization of the financial sector in sight.

At the local level, local governments confiscate the other major source of wealth—land and real estate holding—often giving residents illegally low compensations. Without political accountability and elections, ordinary people can do little to change what amounts to property theft. Even escalating welfare spending in recent years can’t make up for the large transfers of income and savings from ordinary households to the wealthy and connected, which are shaped by government policies.

As a result of all this, ordinary households actually get poorer in relative terms and even in absolute terms. Meanwhile, although growth appears robust, the nature of the growth has changed over time. As Yasheng Huang at the MIT Sloan Business School has documented in his Capitalism with Chinese Characteristics, the healthiest period of growth in China was in the 1980s, when farmers made and sold light manufacturing goods and agricultural outputs to rapidly emerging goods markets. Into the late 1990s, however, China ‘restructured’ its banks so that they could continue to channel cheap loans to state-owned behemoths, now even larger due to consolidation in the 1990s. Growth from that point increasingly relied on net exports and state-led investment and decreasingly on household consumption. Although growth of this sort can continue for a few more years, the vast majority of China’s population won’t see many of the benefits.

Victor Shih is associate professor of political science at Northwestern University and author of ‘Factions and Finance in China’ (Cambridge University Press).